OTC Clearing and the G20

Matt Gravelle

Following the global financial crisis, the G20 has sought to mitigate risk in the over-the-counter derivatives (OTC) markets. The value of outstanding OTC contracts is estimated to be more than $600 trillion USD, most of it interest rate swaps (IRS) (Bank for International Settlements 2013). The market experienced significant losses due the riskiness of these OTC contracts, and in response the G20 targeted these markets for reform in the post-crisis environment. Losses suffered as a result of bad credit default swaps (CDS) by institutions like Lehman and AIG have led to international collaboration on avoiding such losses and the resulting public bailouts in the future (Pagliari n.d.). Both the bailouts and proposals for re-regulation have become cross-border issues. During the 2008 financial crisis, public officials were left to bail out domestic institutions with tax dollars, and also transferred ‘extraordinary liquidity’ through central banks to exposed parties in capital markets around the world. Reshaping these markets has involved considerable cross-border debate. This policy brief focuses on the emergence of a central counterparty (CCP) clearing obligation for OTC.

CCPs have gained prominence in the post-crisis period as a means to increase transparency and lower risk to OTC market participants and taxpayers (Cecchetti, Gyntelberg and Hollanders 2009; Duffie and Zhu 2011). A CCP stands between the counterparties to a contract and ‘clears’ it by becoming both the buyer and the seller of that contract. While technically complex, at root CCPs serve to minimize counterparty risk – that is, the risk that one party to a bilateral transaction will default before the contract matures, leaving the other party to absorb the loss. Given the multiyear maturity of many OTC contracts, the counterparty risk in OTC markets is high, and the risk of contagion is also very high. CCPs utilize financial resources and default protocols that wind-down positions in the event of a default. At the same time, CCPs may increase efficiency, enabling trading counterparties to net their obligations and minimize their collateral requirements. They have the ancillary benefit of giving prudential regulators a look-through at the net positions and exposures of key firms.

At the G20 Pittsburgh Leaders’ Summit, G20 Leaders issued a statement declaring that, “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end- 2012 at the latest” (G20 Leaders’ 2009). Officials from the G20 were thus tasked with legislating and regulating these markets to realize those declared commitments. At the multilateral level, the Financial Stability Board (FSB) has undertaken coordination and monitoring. The Organization of Securities Commissions (IOSCO) with the Bank for International Settlement (BIS) Committee on Payment and Settlement Systems (IOSCO-CPSS) and the BIS Basel Committee on Banking International Supervision (IOSCO-BCBS) have been tasked to develop the technical standards. Most major jurisdictions have now identified and implemented regulatory frameworks (Financial Stability Board 2012; IOSCO-CPSS 2013).

The effort to establish mandatory clearing for most OTC transactions (particularly IRS and CDS) has been politically complex, as it has generated several dilemmas for policymakers. These include market structure concerns (regarding the efficiency and effectiveness of the risk management of monopolies and open-access CCPs) (Stafford 2012), regulatory differences across key jurisdictions (Committee on Capital Markets Regulation 2013; The Alternative Investment Management Association 2013), and problems relating to the pace and sequencing of reforms (minimizing first-mover disadvantages and arbitrage opportunities) (Grant 2012).

Standard setters have struggled to balance efficiency and control. Regulators have had to strike a balance between two competing forces to:

protect domestic economies as well as taxpayers, and so to build oversight and control over OTC transactions and the agencies that clear them; and

avoid nationalization or ‘balkanization’ of rules and transactions along jurisdictional lines which can impose material loses on OTC and CCP users.

Regulators worldwide have been forced to confront this tension head on: ‘clearing’ has historically taken place at large and liquid CCPs with global user bases, particularly for contracts between institutions domiciled in different jurisdictions (LCH.Clearnet n.d.). Moreover, for smaller markets like Singapore, Hong Kong, or Canada, the domestic capacity to clear increased volumes of OTC does not obviously exist. The question has therefore been whether clearing will now take place at new (or newly revamped) onshore CCPs or whether they will be allowed to continue to clear at foreign CCPs regulated by foreign authorities.

A series of initial regulatory signals suggests that onshore clearing was the preferred solution for many jurisdictions, particularly with regards to OTC products of systemic importance.

In 2011 the Australian government blocked a proposed merger between ASX, the Sydney exchange and clearing firm, and Singapore’s SGX, due to an inability to maintain “full regulatory sovereignty over the ASX-SGX holding company (Australian Treasury Press Release 2011).

Similar concerns motivated the Bank of Canada in its examination of 2011’s proposed merger between the London Stock Exchange and TMX (which owns the major Canadian derivatives CPP, Montreal’s CDCC) (Grant and Simon 2011)

The primary US derivatives regulator, the Commodity Futures Trading Commission (CFTC), has repeatedly emphasized Dodd-Frank statutory language about regulating activities that “have a direct and significant connection with activities in, or effects on, commerce in the US” (CFTC 2012).

Europe’s CCP legislation (EMIR) contains language with a similar extra-territorial impact that generates obligations for “contracts having a direct, substantial, and foreseeable effect within the Union.” It creates an obligation for such contracts to be cleared at CCPs approved by the European Securities Market Authority (Grant and Barker 2011; Watt 2012).

Since those initial trends towards domestic oversight, however, policy momentum has shifted towards cross-border recognition and cooperation. Many regulators have agreed that overseas CCPs, if subject to ‘equivalent’ foreign regulation, may allow domestic firms to fulfill their home-market clearing obligations. A policy of ‘mutual recognition’ (or, sometimes, ‘substituted compliance’) has replaced the move towards the domestication of clearing, allowing CCPs to offer services to clients in foreign jurisdictions while complying only with their domestic rules (Tafara and Peterson 2007).

The Bank of Canada has authorized Canadian institutions to clear at ‘global CCPs,’ emphasizing that the control versus efficiency trade-off is too steep to justify the mandatory use of Canadian CCPs, but expressing confidence that the rules governing those institutions will protect Canadian markets (Bank of Canada 2012). Australia’s ASIC and RBA have published detailed guidance on their regulatory assessment protocols for foreign CCPs and plotted a middle ground strategy to ensure ‘Australian influence’ over CCPs that are systemically important to Australia but domiciled abroad (The Council of Financial Regulators 2012; RBA n.d.; ASIC n.d.).

Hong Kong has moved away from the location requirement in its earlier consultations (HKMA and SFC 2012), and Singapore has mooted the recognition of overseas CCPs for the purposes of its mandatory clearing rules (Monetary Authority of Singapore 2012; Monetary Authority of Singapore 2013). Japan similarly proposes the authorization of overseas CCPs for certain types of OTC. And perhaps most surprisingly, the EU and US have backed down from a stalemate on transatlantic clearing with a last minute ‘Path Forward’ announcement on July 11, 2013 (CFTC 2013). In declaring each other’s regimes to be ‘essentially identical,’ the US and EU have accepted the interconnectedness of the transatlantic market, while establishing a high-level blueprint for a more cooperative approach to regulation. This momentum shift may be attributed to several factors. The G20 has encouraged multilateral development, through the FSB, of mechanisms to assist the cooperative implementation of G20 goals and “avoid cross-border conflicts, inconsistencies, gaps and duplicative requirements” (G20 Leaders’ Moscow 2013).

The development of supplementary multilateral frameworks, notably those released by the FSB and IOSCO-CPSS, have been crucial for this ‘deference’ to be possible (IOSCO-CPSS 2012; FSB 2012). These sets of principles offer a baseline against which regulators may measure foreign approaches to CCP regulation, giving them confidence in authorizing the use of foreign CCPs that comply with comparable rules and seek similar policy outcomes. National regulators have innovated to develop their own protocols to assess equivalence and build-in cooperative oversight of foreign CCPs. National assessment protocols and bilateral cooperation agreements are essential components of the emerging cross-border CCP regime.

The OTC marketplace underlines the deeply interconnected nature of the markets and the complex entities that transact in them. Where multiple regulators assert clearing obligations on their home turf, it is nearly impossible to avoid the imposition of duplicative regulations. Some form of mutual recognition seems an appropriate compromise, given those constraints. The increasing willingness to accept mutual recognition has relied heavily on the multilateral standard and principle-setting activities. The G20, FSB and IOSCO-BIS have developed successful efforts to harmonize CCP governance standards, and thus give regulators confidence that risks are being mitigated abroad as well as at home, are essential components of this exercise (Singer 2007).

Still, the cross-border politics in this issue area are far from settled, and are now entering a new phase. Measuring and making determinations of overseas regime equivalence is a necessary step before a regulator decides to enter a mutual recognition arrangement, but that assessment has the potential to be both arduous and controversial. Multilateral efforts will be important, but regulators will be under tremendous domestic pressure from their political bosses, prudential regulators, and local financial service interests.

In short, the ultimate shape of this complex cross-border system is yet far from clear.